Securities lending can be a lucrative activity for mutual funds, but many mutual fund investors are unaware of the inherent risks in securities lending due to a lack of transparency. In short, securities lending describes the process whereby the managers of mutual funds and ETFs lend out shares they own in their portfolios for a short period to parties like hedge funds in exchange for a fee (like banks lending our their depositors’ funds). Of course, the investors in the fund/ETF own the underlying shares. The key difference is, unlike FDIC insurance that protects depositors, there is no insurance in securities lending to protect investors should a securities lending transaction go bad. This is the crux of an article co-authored by three Heider College professors and published in a recent issue of Journal of Business Ethics.
Lee Dunham, PhD, CFA, associate professor of finance, Randy Jorgenson, PhD, CFA, professor of finance, and Ken Washer, DBA, CFA, CFP, professor of finance, collaborated on “Securities Lending Activities in Mutual Funds and ETFs: Ethical Considerations.” The article examines ethical questions related to securities lending activities of mutual funds and ETFs and offers a series of best practices aimed at providing better transparency of activities to investors.
Dr. Dunham had published two previous papers that quantified the impact of securities lending on index mutual funds and ETF performance. He found that while ETF/fund investors did receive some of the fee collected, they did not always receive all of it. In many cases, the fund company kept a portion of the fee. However, in the few cases where the borrower did not return the shares, the investors were left to bear the entire loss. He felt that most investors were probably not aware of this asymmetric risk-return profile inherent in securities lending programs. So he had an idea for a new paper that focused on the ethics of these programs.
He sought the help of Dr. Washer and Dr. Jorgenson. Drs. Washer and Dunham had previously published a paper that addressed the ethics of corporate executives hedging their stock positions in companies for which they. Heider College’s in-house finance ethics expert, Dr. Jorgensen, was a natural partner for the new project.
“Collaborative research often leads to ideas that one person may not think about if working individually,” says Dr. Dunham. “It also leads to a better written paper in most cases.”
Lack of transparency is a problem with which the investment and securities industry is grappling, says Dr. Jorgensen, especially when risks to investors are not disclosed.
“We thought it important to highlight what those risks are and why investors deserve a clearer disclosure of them,” he maintains.
Ethics is a large component of the course work at Heider College. Dr. Dunham reminds his students that, as investors, they must be diligent in ascertaining whether their ETF or mutual fund is engaging in securities lending, and to what degree, and how much of the securities lending income is kept by management and what portion is received by the investor. This can be difficult because, says Dr. Dunham, “there are very little required disclosures surrounding these problems.”
Dr. Jorgenson teaches ethics as part of the Master of Investment Management and Financial Analysis (MIMFA) graduate program. “It’s important that students be able to understand and evaluate practices they run across that might not feel quite right.”
The Journal of Business Ethics is on the prestigious Financial Times (FT) 50, a list of top business journals used by leading business schools to assess quality of faculty research. Given the significance Creighton places on ethics, the journal is a worthy home for Heider faculty research and writing.
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